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Abstract
The major finding is that liquidity costs in futures options market are two to three times higher than
liquidity costs in the futures market. Liquidity cost is one potential factor to consider when choosing
between hedging with a futures contract or with an option contract. While there is considerable research
that estimates liquidity costs of futures trading, there is little comparable research about options markets.
This study, for the first time, attempts to determine and compare liquidity costs in options and futures
markets. The study uses July 2007 wheat futures and options contracts traded on Kansas City Board of
Trade. Two measures of liquidity costs were used for both options and futures markets. One measure of
liquidity costs in options markets is the average bid-ask spread that is calculated from the available bidask
quotes. A new measure of liquidity costs in options markets is derived based on the Black model and
it uses trade prices instead of observed bid-ask quotes. The liquidity costs in the options market was
estimated to be 1.60 cents per bushel using observed bid-ask spreads and it was 1.37 cents per bushel
when the new measure was used. Liquidity costs in the futures markets are estimated using Roll’s
measure and average absolute price changes. The estimates were 0.45 and 0.49 cents per bushel,
respectively for futures contracts. A positive relation was found between option liquidity costs and
moneyness of the option. Days to expiration of the contracts was not statistically significant in explaining
the liquidity cost of the option.